Accrual Accounting for Governments

The IMF has launched its Public Financial Management blog. Yesterday’s post by Abdul Khan discusses the transition to accrual accounting accounting which records revenue when earned and expenses when incurred rather than when cash is transferred for governments at the national and subnational levels

A little Accounting 101 can yield some insight into the implications of this accounting methodology: Cash-basis accounting, which is still used by most governments, does not record 1) revenue and expenses that occur with a cash flow lag and 2) non-cash transactions. Unlike cash accounting, accrual accounting does capture accounts receivable (revenue yet to be collected, such as investment income), accounts payable (bills yet to be paid, such as unfunded pension liabilities, veterans’ benefits) and accrued expenses (unbilled & estimated expenses yet to be paid, such as public debt interest). Another big difference between cash and accrual accounting is that cash accounting records the depreciation of capital (such as infrastructure, defense procurements) as capex or capitalized depreciation, which is credited to cash flow, whereas accrual accounting records accumulated depreciation, which is debited from assets. As a result, a government’s cash flow can still be positive even in a steady-state scenario (no change in revenue or expenses) – but its balance sheet (the stock of assets and liabilities) may be out of whack.

In the past 10 years, countries such as Australia, New Zealand, Sweden, Canada, EU, UK, USA and others (mostly advanced economies – transition costs can be prohibitive for smaller economies) have begun moving into accrual accounting for government financial reporting and budgeting. Emerging markets, like India and Malaysia, are considering introduction; South Africa, Mongolia and Hong Kong began introduction, albeit slow and limited; UAE completed its transition this year. Latin American countries use accrual accounting for parts of the public sector.

Accrual accounting alone does not generate greater transparency on fiscal health. The US government uses both accrual and cash accounting methods but more heavily publicizes the national debt determined by cash accounting than by accrual accounting – national debt looks smaller with cash accounting (see Bartlett). The government leaves the Treasury’s U.S. Financial Report (which uses accrual accounting) in obscurity while touting its ostensibly healthier budget report (which uses cash accounting). Cash accounting may be useful for budget appropriations but it does not elucidate the public sector’s financial condition for the period under observation.

One critique of accrual accounting, from Kent Smetters in Harvard Journal on Legislation, is that it “overestimates the true liability that the Social Security system is passing to future generations because the accrued measure fails to net out the future taxes that will be paid by younger and richer workers in excess of their future benefits…The key problem with accrual accounting is that it gives a sense that Social Security benefits accrued to date are somehow ‘bonded,’ that is, that they represent legal liabilities in the same sense as government debt.”